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Welcome to the business of certainty. When you need to understand the companies in your ecosystem, you’ll benefit from a certain approach. We capture and treat private company information for better decision making and increased efficiency.

Capital questions

In trying to evaluate the credit standing of banks in different markets, we asked three crucial questions:

What are the lessons to be drawn?

How much capital is enough?

And what do we know post-financial crisis?

Addressing them in detail were:

Claude-Vincent Gillard, chief production officer at Bureau van Dijk, whose company information databases – including information on banks – are used by researchers to, among other things, assess the financial strength of organisations; and

Sarah de Quant, a managing partner at Adeva Partners, which provides highly tailored training solutions and consulting services in credit and risk. This includes their unique eWorkbook series, which equips analysts to expand and improve the knowledge and skills they need to analyse a bank.1

As well as covering a raft of planned material on stress testing, the webinar saw its audience pose a number of questions, which Claude-Vincent and Sarah deftly handled – you can watch the whole recording here.

But there wasn't time to answer them all. So a few days later I caught up with one of Sarah's colleagues, Anne-Marie Barcia, a fellow managing partner at Adeva, to get her take on the webinar and to fill us in on some of the unanswered questions. She was very generous with her answers.

Q&As

I started by highlighting one of the main themes that emerged in the webinar: that of people seeking clarity about the future of regulation and the banks' ability to provide decent returns to shareholders going forward. What are Anne-Marie's thoughts on that?

Anne-Marie Barcia: "Let's take each of these questions in turn, starting with the banks' profit dynamics and shareholder returns in excess of the cost of capital. How can banks continue to meet all the regulatory requirements while also providing a return on equity to shareholders?

"The current environment is challenging as regulators have sought to de-risk the banks' activities. Pre-crisis, many CEOs promised shareholders returns on equity in the range of 18 to 20%. That is now, clearly, a thing of the past. But can banks generate earnings beyond a level that meets their cost of equity? With the bar set low, we think yes, they can, but only once they sort out their risk profile.
"US banks are a good example. They have de-risked their balance sheets substantially and equity betas are now well below 1, meaning that their relative volatility to the market is low. Given this fact and the current low interest rate environment, NYU Stern Business School estimates a current cost of equity of 7.34% for US money centre banks, meaning that shareholders need to get a return of at least this to justify the investment. Most of the large US banks are achieving an RoE [return on equity] in excess of this.

"As discussed during the webinar, European banks – and those in many emerging markets – still have a much higher risk profile, evidenced by betas substantially above 1 for European banks, and consequently they have a higher cost of capital.

"Having said that, on both sides of the Atlantic and indeed all around the world, bank earnings are likely to continue to stay under pressure for a number of regulatory related reasons: (i) earnings are squeezed by the requirement to hold a higher proportion of low risk, liquid assets; (ii) the cost of compliance continues to rise, as the regulations are increasingly complex and all pervasive – executives and staff are held accountable to higher standards; and (iii) the cost of fines and legal expenses related to misconduct – with continued scrutiny – may persist even after legacy issues have been settled.

"This is before we even start talking about competition from fintech and non-banks."1

Alistair King: "One of the questions asked was this: following the US lead, will the Basel Committee on Banking Supervision impose higher capital requirements on its banks by placing restrictions on the use of the IRB [internal ratings-based] approach to calculate risk weighted assets [RWA]? What are your thoughts on that?"

AMB: "Good question! And of course we don't yet have the answer. The committee keeps delaying their final conclusions. The Americans were the ones pushing for standardised floors with the Europeans generally resisting.

"We think some form of increased capital requirements through standardised floors may be introduced but perhaps with a very long phase-in period. Large institutions in a number of EU countries struggle to meet the current standards and any increase is likely to lead to the need for further downsizing.

"Remember, like in emerging markets, companies in the EU are more reliant on banks for funding than in the US."

AK: "Another earnings and capital-related question we received was about the impact of rising dollar interest rates and what that might mean to Tier 1 Capital ratios for US banks and for those in other countries. What are your thoughts?"

AMB: "Rising rates are a double-edged sword for banks. In some countries, banks may waive transaction fees on retail bank accounts on the basis that the benefit of non-interest bearing deposits will more than offset the cost. This, of course, is a fallacy in a low interest rate environment – so from this perspective, higher interest rates are welcomed. When the data is disclosed, the Orbis Bank Focus spreadsheet highlights the potential impact of a 100 basis point (1%) move in interest rates on a bank's net income – normally a rise is a significant positive. This should feed through into higher capital generation. Indeed, emerging market banks have historically benefited from higher interest rates and very good capital generation.

"On the flip side, higher interest rates often lead to an increase in non-performing loans [NPLs] as marginal borrowers struggle to meet the higher costs of borrowing. In evaluating how much capital is 'enough', we need to consider the bank's business model and where it is in the credit cycle. For US commercial banks, 'these are the good ole days' with NPLs at relatively low levels. For example, look at the data on the Orbis Bank Focus US Bank peer analysis template, where the ratio of NPL to total loans is currently in the 2 to 3% range.

"The future outlook is a crucial factor in assessing a bank's capital adequacy. For those banks nearer to the top of the cycle, the analysts need to make a judgement as to whether the bank is likely to have sufficient capital to cope with the eventual downturn under different stress test scenarios that reflect that bank's business model. Regulatory stress test results can be very helpful in this regard. For example, the UK regulator requires banks to assess a borrower's ability to service their mortgage at significantly higher interest rates.

"Since the sector is cyclical, what about the capital adequacy of those still stuck in the mire? As I say, higher interest rates will lift earnings in some facets of their business but rising NPLs will more than likely offset the benefits and could challenge their already weakened capital positions even further."

So there we have it. The answers aren't simple. But they're certainly thorough and robust enough to withstand some stress testing of their own.

How Bureau van Dijk can help you

Certainty is a highly-prized commodity in business. Data might be getting bigger all the time, but this only makes extracting value from it more difficult.

In capturing and treating private company information we aim to give you more certainty –
and help you make better decisions and work
more efficiently.

Our solutions are designed to help different business challenges and streamline your workflow. Many of our customers blend our information with their own internal data to get a more complete picture of the companies in their ecosystem.